Wednesday, December 22, 2010

Quote of the Day: Mark Perry and Robert Dell

The banking crisis that began in August 2007 shocked markets and precipitated the Great Recession. To fully explain the banking crisis, one must account for its timing, severity, and global impact. For example, why didn’t a banking crisis erupt sooner—say, in the recession years of 1990-1991 or 2001-2002? What changed in recent years that led to business risk-taking capable of wrecking the U.S. housing market and the U.S. banking system and other banking systems throughout the world? Further, why were prudent credit practices reasonably maintained in credit card and commercial mortgage securitization in recent years, but wholly abandoned in residential mortgage securitization?

In answer to the questions about what specific factors explain the: causes and timing of the banking crisis and the extraordinary departure from historically sound underwriting and securitization standards for residential mortgages, we identify a potent mix of six major government policies that together rewarded short-sighted collective risk-taking and penalized long-term business leadership.

Bank misregulation, in particular the international Basel capital rules, including a U.S. adaptation to them—the 2001 Recourse Rule—and the outsourcing of risk assessment by regulators to government-sanctioned rating agencies incentivized (not merely “allowed”) the creation and highly-leveraged systemic accumulation of the highest yielding AAA- and AA-rated securities among banks globally.

Continually increasing leverage—driven largely by Fannie Mae and Freddie Mac credit policies and the political obsession with taking credit for increased homeownership—into the U.S. mortgage system. Reduced down payments and loosened underwriting standards were a matter of government policy throughout the housing boom.

The enlargement of the riskier subprime and Alt-A mortgage markets by Fannie and Freddie through the abandonment of proven credit standards (e.g., dropping proof of income requirements) during the 2004-2007 period, and their combined accumulation of a $1.6 trillion portfolio of these loans to meet the affordable housing goals Congress mandated.

The FDIC, Federal Reserve, Treasury Department, and Congress undertook explicit or implicit creditor bailouts for large financial institutions starting in the 1980s (First Pennsylvania, Continental Illinois, the thrift industry, the Farm Credit System, etc.) and continuing to 2008 (Bear Stearns). These regulatory decisions led to an absence of creditor discipline of financial institution leverage and risk-taking (especially at Fannie and Freddie) and the “too big to fail” expectation of a government bailout.

The increase in FDIC deposit insurance from $40,000 to $100,000 per account in 1980 combined with the unchecked expansion of coverage up to $50 million under the Certificate of Deposit Account Registry Service beginning in 2003. These regulatory errors of commission and omission reduced the incentives of business, institutional, and high net-worth depositors to monitor and discipline excessive bank leverage and risk-taking.

Artificially low and sometimes negative real federal funds rates from 2001 to 2005—a result of expansionary Fed monetary policy—fueled the subprime and Alt-A mortgage boom and widened the asset-liability maturity gap for banks. Most subprime and Alt-A mortgages carried low initial rates made possible by low federal funds rates, which spurred borrower demand for these mortgages.

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Grouch: I find it hard to argue against the conclusions of Perry and Dell. The distortions the government caused in the mortgage markets through misguided, well-intentions policies are readily apparent to anyone taking an unbiased look at the recent financial crisis. The Frank-Dodd financial reform bill has, in essence, planted the seeds for the next financial crisis by giving government an even bigger role. What's needed instead: 1) the gradual dissolution of the GSEs Fannie and Freddie, and the ceasing of Congressional meddling in these organizations (I would prefer them to go out of business altogether), 2) a reduction in Federal Deposit insurance and the implicit creditor guarantee that banks will be bailed out of their bad behavior, 3) the elimination of regulator micro-management (which has failed miserably in the past) in favor of higher capital requirements, and 4) some kind of oversight of the Fed to prevent the setting of artificially low interest rates.

2 comments:

Can I add a 7th point that there were a lot of either misinformed or overreaching people out there that took out more loans than they could afford to pay? Sure, the system let them do it, but you gotta have some common sense too.

I agree with that point as well. Personal responsibility and accountability seem to be a thing of the past. On every house I've ever bought, I know I made damn sure I could easily afford the monthly or I didn't buy that house or sign up for that loan.

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I am a fifty-something year old father of three who has been happily married for 25 years. I am interested in money management, and software development. I've been a steady investor for all of my life and have typically been successful when I've followed my own instincts, and been less successful when following the advice of others. Some of the people I look up to in the investment world are Warren Buffett, John Templeton and Jack Bogle.